How to Smoke the Market

"Sin" stocks, businesses involved in alcohol, tobacco, weapons, gambling, and other morally ambiguous and permanently controversial areas, are not the types of investments you're likely to go telling your neighbors about. That said, a few "sin" companies are worth more than a mere furtive glance. I've found three businesses in alcohol and tobacco with the potential to be great investments.

Tobacco is wacko -- if you hate moneyWarren Buffett, arguably the greatest investor of all time, has said this about the tobacco industry:

I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.

It's hard to get the brand loyalty that tobacco behemoth Reynolds American (NYS: RAI) has built for itself over time. Its cigarette portfolio alone -- with brands such as Camel, Winston, Pall Mall, and Kool, to name a few -- has the sort of devoted mass following that rivals dream about. Add to that the Grizzly and Kodiak brands in its snuff lineup, and you have one strong, diversified nicotine-based empire.

However, Reynolds' main strength as an investment stems from its dividend, which stands at a smokin' 5.2%. Now if that's not healthy, I don't know what is! While Reynolds' products don't necessarily epitomize safety for the consumer, the wise investor can count on Reynolds for a hefty dividend.

But beware, income investors, of something called the payout ratio. This metric represents the fraction of net income distributed to stockholders in the form of dividends, and Reynolds' payout ratio is currently 96%. In the tobacco industry, this number tends to be pretty high, since the businesses are already well-established, mature companies that can afford to reward their shareholders through dividends. But 96% is still a little steep -- the industry average is 71% -- so if you're an investor, keep an eye on that number and make sure it doesn't trend upward too dramatically. This is doubly true for investors in fellow tobacco giant Altria Group (NYS: MO) , whose dividend is also appealing at 4.7%.

If you booze, you can't loseBrazilian company AmBev (NYS: ABV) , a subsidiary of Anheuser-Busch InBev (NYS: BUD) , is the largest brewery in Latin America, and it's also one of the largest independent PepsiCo bottlers in the world. AmBev is an exceptionally attractive company, and it's not because I've been drinking. It's because AmBev's margins are so high it looks as if they've been drinking. Whatever it is, I'll have one. Net margins stand at 32% -- nearly double the industry average. And these margins aren't a one-time deal. Over the past five years the company has, on average, been -- you got it -- about twice as profitable as its average competitor.

Did I mention that AmBev pays around a 3.7% dividend and trades at a P/E almost negligibly higher than its peers? No, I didn't. But now you know.

Anheuser-Busch is another prominent brewer that will shell out some cash while you watch your investments play out. Its current yield is nearly 2% per year (with a payout ratio of only 27%), it's the largest brewer in the world, and its trailing year earnings are up more than 90% from the year prior. Add to that a portfolio of some of the world's leading brands (Budweiser, Beck's, and Hoegaarden, to name a few), and you have the makings of a tasty investment.

A handful of "sin" equities are well positioned for market outperformance. Sturdy dividends, powerful brands, and customer loyalty are a few reasons these stocks are so attractive. In particular, I strongly believe in Reynolds American's ability to beat the market, which is why I made a thumbs-up CAPScall on the stock back in November.